How Anchored Expectations Reduce the Cost of Disinflation
Anchoring inflation expectations significantly reduces the economic cost of disinflation, measured in terms of lost output and higher unemployment. When expectations are firmly anchored, wage and price setters trust that the central bank will bring inflation back to its target. Consequently, even after a shock causes a temporary price increase, the Phillips curve does not shift upward. This stability allows the central bank to restore the inflation target with a less severe policy tightening, requiring only a move to the new supply-side equilibrium rather than inducing a deep recession.
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Introduction to Macroeconomics Course
Ch.4 Inflation and unemployment - The Economy 2.0 Macroeconomics @ CORE Econ
The Economy 2.0 Macroeconomics @ CORE Econ
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Ch.5 Macroeconomic policy: Inflation and unemployment - The Economy 2.0 Macroeconomics @ CORE Econ
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Definition of Anchored Inflation Expectations
How Anchored Expectations Reduce the Cost of Disinflation
A country experiences a sudden, temporary surge in the price of imported oil, leading to a one-time increase in the general price level. Why would its central bank be most concerned about how the public and businesses react to this news in terms of their future price forecasts?
Central Bank Credibility and Inflation Dynamics
The Self-Perpetuating Nature of Unanchored Inflation Expectations
A central bank's primary focus for maintaining price stability should be on controlling the current money supply, making public expectations about future price levels a secondary and less critical concern.
Comparing Policy Challenges with Different Inflation Histories
How Anchored Expectations Reduce the Cost of Disinflation
Imagine two countries, Country A and Country B, both of which have a central bank with an official inflation target of 2%. The central bank of Country A has a long, established history of consistently taking action to keep inflation near 2%. The central bank of Country B, however, has a history of frequently allowing inflation to drift far from its 2% target without a decisive response. If both countries experience an identical, unexpected economic shock that temporarily pushes inflation up to 5%, in which country are long-term wage and price-setting behaviors more likely to remain stable, and why?
Central Bank Credibility and Inflation Expectations
The Mechanism of Anchoring Inflation Expectations
The Consequences of Unanchored Inflation Expectations
A central bank that consistently allows inflation to remain above its stated target without taking decisive action will find that the public's long-term inflation expectations become more firmly anchored to the official target.
Match each description of a central bank's policy history with the most likely state of the public's inflation expectations in that country.
A country's central bank, previously known for inconsistent policies, wants to firmly establish its credibility and anchor the public's long-term inflation expectations at a new, lower target. Arrange the following events in the most logical sequence that would lead to this outcome.
A country's central bank has maintained a credible 2% inflation target for many years, leading to stable public expectations. A new government administration begins to publicly pressure the central bank to tolerate a higher inflation rate (e.g., 4-5%) for the next several years to stimulate short-term economic growth. If the central bank yields to this pressure, what is the most significant long-term risk associated with this policy shift?
Central Bank Policy Choice After a Supply Shock
In an economy where the central bank has a long and credible history of maintaining its 2% inflation target, a sudden, temporary increase in energy costs pushes the current inflation rate to 5%. In this scenario, businesses and workers are less likely to build this 5% rate into long-term wage negotiations and price-setting decisions because they expect the central bank's actions will cause inflation to ultimately ____.
Learn After
Reduced Cost of Disinflation with Anchored Expectations Despite Policy Delays
Comparing Disinflationary Policies
Two countries, Credibilia and Volatilia, both have central banks targeting 2% inflation. Credibilia's central bank has a strong, long-term track record of meeting its target, and the public firmly believes it will continue to do so. Volatilia's central bank has a history of inconsistent policy, and the public is skeptical about its commitment to the 2% target. If both countries are hit by an identical, temporary external shock that pushes inflation to 5%, which outcome is most likely?
The Role of Expectations in Disinflation
The Economic Cost of Disinflation
An economy with well-anchored inflation expectations experiences a temporary adverse supply shock that pushes inflation up. Arrange the following events in the most likely chronological order as the central bank works to bring inflation back to its target.
If a central bank has successfully anchored inflation expectations at its 2% target, a temporary supply shock that pushes inflation to 5% will cause a permanent upward shift in the relationship between inflation and unemployment, forcing the central bank to induce a severe recession to restore price stability.
Match each economic scenario describing inflation expectations with the most likely outcome regarding the economic cost (in terms of lost output or higher unemployment) of reducing inflation.
Central Bank Policy Dilemma After a Supply Shock
An economy has a long-established and credible central bank that targets 2% inflation. A temporary global supply disruption causes inflation to spike to 5%. The central bank reaffirms its commitment to the 2% target. Why is the economic downturn required to bring inflation back to 2% likely to be less severe in this economy compared to one with a less credible central bank?
When a central bank has established strong credibility, an unexpected rise in inflation may not lead wage and price setters to demand large increases, because they trust the inflation spike is temporary. This phenomenon, known as having well-______ expectations, prevents a persistent upward shift in the inflation-unemployment trade-off, thereby reducing the amount of lost output needed to return to the inflation target.